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What is CRR?

Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.

CRR is essentially a monetary policy tool to control liquidity and paying an interest will infuse cash into the system.

In the recent period, the policy focus has been on devising measures to reduce banks’ lending rates. It has been mooted by some policymakers that scheduled commercial banks should be paid 7 per cent rate of interest on the cash reserve ratio (CRR) balances held with the Reserve Bank of India (RBI). The issue of paying interest on CRR balances is a long saga. From the latter part of the 1970s to 1990, interest on CRR balances was raised gradually from 5 per cent to 10.5 per cent.
HIGHER INTEREST RATE

The rationale for increasing the interest rate on CRR balances was that increased CRR prescription lowered the profitability of banks and, therefore, to shore up profits, lending rates were being kept high. To moderate lending rates, interest on CRR balances was gradually raised. In the 1980s, there was a fascinating debate in the RBI on the question of paying interest on CRR balances. One view was that the interest rate on CRR balances should be raised as a pragmatic measure, while the other view was that, analytically, it would be wrong to pay interest on CRR balances. Eventually, the pragmatic view prevailed and the interest on CRR balances was gradually raised. The upshot of raising the interest on CRR balances was that the CRR, which was a powerful tool of monetary control, was gradually rendered totally impotent. The amount of interest paid on the outstanding CRR balances rose, and eventually the annual interest on the CRR balances was higher than the annual increase in the balances impounded during a year.
EFFECTIVE CRR LEVELS

In response to this, the RBI was forced to increase the CRR prescription. Eventually, the CRR prescription reached the statutory ceiling of 15 per cent of net demand and time liabilities (NDTL). The statutory ceiling was thereafter raised to 20 per cent. By 1992, the effective CRR was 16.5 per cent of NDTL. From April 1990, the policy tilt was towards reducing the effective interest on CRR balances. Under a two-tier formula, interest was paid at 10.5 per cent on cash balances relating to the liabilities up to

while some do. and eventually abolished in 1992. on the incremental liability. Each country has to tailor its instruments to its specific environment. To maintain the same degree of control. an additional Rs 38. say.the end of March 1990. under the present CRR prescription of 4. As a result. but Rs 25.000 would be paid out as interest on the entire CRR balances. if the NDTL in a year rises by. the effective interest rate on cash balances progressively came down to 3. an element of monetary control has been regained even though the prescription is as low as 4.75 per cent to 2 per cent.5 per cent. no interest is paid on CRR balances.75 per cent (without interest) would need to be raised progressively and. With the amendment of the RBI Act. In other words. over time.75 per cent. A number of countries do not pay interest on CRR balances. As no interest is paid on CRR balances. the present degree of monetary control would require that the CRR prescription be raised rapidly. If interest is paid at a rate of 7 per cent as proposed by the Ministry of Finance. Illustratively. the interest rate on CRR balances was lowered to 8 per cent.000 crore. from 2007. the CRR instrument would become totally ineffective.75 per cent. the present prescription of 4.000 would be impounded. Rs 8. the effective CRR would be reduced from 4. in incremental terms.00. .